When real estate investment property is acquired in a 1031 exchange, the seller is prohibited from taking “constructive receipt” of the proceeds from the sale of the relinquished property during the exchange period. If the seller constructively receives the proceeds, the exchange becomes null and void, and the seller must pay taxes on the property as he would in a traditional real estate sale.
THE PURPOSE OF CONSTRUCTIVE RECEIPT
The IRS created the concept of constructive receipt to prevent investors from receiving unfair financial advantages when acquiring investment properties in 1031 exchanges, such as using proceeds from the sale to fund an investment, such as a short-term CD, and then using the money to acquire another property in a tax-free exchange. This is why the IRS requires investors to have a Qualified Intermediary (QI) hold the funds from the sale while an exchange property is identified.
However, the IRS also makes provisions for sellers to access sale proceeds without eradicating the 1031 exchange. One way to do this is to “take boot,” which is to receive proceeds outside of the exchange period. Another way to access proceeds without terminating the exchange is to structure a built-to-suit-exchange.
TAKING BOOT AND BUILT-TO-SUIT EXCHANGES
Boot can be taken at the closing of the sale of the relinquished property or the closing of the sale of the replacement property. However, because the money is taxable, brokers generally advise against taking boot when buying investment properties in 1031 exchanges. However, if the investor needs money to fund another investment whose proceeds would more than offset the tax burden, then taking boot may be a smart decision.
A built-to-suit exchange operates by different rules than taking boot. The exchange is structured so that the investor can take a specified portion of the proceeds from the sale of the relinquished property to make improvements to the acquired property. A built-to suit exchange is an excellent option when a property must be improved for a tenant to inhabit it.
The concept of constructive receipt is not as rigid as it initially seems. However, before you elect to take boot when buying investment properties in a 1031 exchange or decide that a built-to-suit exchange is the best way to acquire the real estate investment property you need, schedule a free consultation with Westwood Net Lease Advisors. We have extensive experience facilitating 1031 exchanges for private and institutional investors, and will advise you on the best way to achieve your investment goals.